Microfinance Focus, January 10, 2010: The past few years have seen the entire microfinance sector grow exponentially. As with any other boom, suspicion always exists on whether a bust is just around the corner. This is especially true in the current international setting; with a major financial bust that humbled Alan Greenspan to admit he was “in a state of shocked disbelief”. In hindsight, it might seem obvious that the years of heady growth directly resulted in the sub-prime crisis and credit crunch. This heightens the sense of unease over the rapid growth of the microfinance industry and one is often seized of whether we are sitting on a bubble waiting to burst.

Daniel Rozas’ piece in an edition of Microfinance Focus titled “Is There a Microfinance Bubble in South India?” highlighted this point and indicated that the microfinance industry in India; especially Andhra Pradesh; could be on the verge of a bubble.  Microfinance Institutions Network – MFIN, the newly created association of NBFC MFIs, welcomes this open discussion on the topic – particularly so, since it has been seized with this issue of potential over-lending to borrowers. As Daniel mentioned, the quest for rapid growth could lead a company or industry to not realize the bubble they have been building up during this growth phase.

Defining a bubble

To get a more definitive idea of what characterizes a bubble; one needs to look no further than our friend, Alan Greenspan. He is credited with first using the succinct term ‘irrational exuberance’ in a 1996 speech. This term encapsulates the crux of any bubble – the divergence of asset valuation with its true value. In the case of microfinance, a bubble will be created if a significant number of members are funded beyond their repayment capability. The challenge is therefore to limit the total loan exposure to a member – and therein lies the unasked question in Daniel’s piece. Instead of focusing only on the number of people serviced by microfinance, one should ask if the credit exposure of a large section of these people is beyond their repayment capability. Couple of analogies will help highlight the difference in the approach:

1. The sub-prime crisis was caused by combination of people’s inability to repay their loans and the over-valuation of the underlying asset – the debtor’s home. It would be wrong to presume that simply because 100% of the market was served by mortgage loans, a bubble was created. If every debtor was given a mortgage loan commensurate to her repayment capacity as well as home value, we would have 100% of the customers serviced without any bubble.
2. Consider the rice/wheat market in India.  Almost every household purchases these staple items; but it can hardly be said that a bubble exists in the rice/wheat markets. In fact, a large section of the population does not have sufficient grains.

In order to obtain a better sense of the bubble-vulnerability of the Indian microfinance sector, an analysis of members’ loan exposure levels versus their repayment capability needs to be conducted. Information of such granularity is not easy to obtain; and hence Daniel’s proxy measure carries value. It points out the level of multiple-borrowing by members, especially in Andhra Pradesh. In fact, it is this precise issue that the MFI sector seeks to address through collaboration among MFIs.

Alpha & MFIN initiatives

This year, around 30 leading NBFC-MFIs that accounts for around 85% of the Indian market have come together to form Alpha Micro Finance Consultants P Ltd. Alpha will help get the credit bureau services made available to the MFIs in the country.

As a first step, Alpha has initiated discussions with a couple of Credit Information Bureaus to establish bureau services for all member-MFIs. This will help maintain a common database of borrowers; which will improve the ability of an MFI to evaluate a borrower’s credit-worthiness before disbursing the loan to her. Alpha intends to engage 2 bureaus; including an investment in one of them as a mark of its commitment. To bolster the rollout of this initiative, Alpha has established a partnership with the Omidyar Network and the IFC. IFC will provide technical support to Alpha as well as member-MFIs in getting themselves technically ready to be ‘bureau ready’ so that they could use this data base to get a full idea of a client’s total indebtedness and credit behavior before taking a call to lend further.

Of course, Alpha recognizes that a credit bureau is not a solution in itself.  After all the sub-prime crisis in the USA was not due to lack of data . To optimize the benefit for the industry through this engagement with credit bureaus, the NBFC-MFIs have come together to create an association, Micro Finance Institutions Network (MFIN).

MFIN has formulated a Code of Conduct; which will require member-MFIs to adopt certain processes and be subject to certain limitations that will limit over-lending to a borrower. This Code of Conduct, in tandem with the enrollment to the Credit Bureaus, will form a strong industry-initiative to pro-actively restrict over lending and associated pains
In addition, Alpha has also had preliminary consultations with the Unique Identity Development Authority of India (UIDAI). Alpha believes it could provide a valuable service to the nation by serving as a channel for verification and enrollment of millions of lower-income household members in the UIDAI database.

It is expected that such an exercise will also prove beneficial to Alpha since MFIs will be able to identify each of their members individually with their unique ID. This ID will empower MFIs to be completely certain of any borrower’s prior exposure to other MFIs.

We believe that these measures will enable the microfinance industry to responsibly serve the microfinance needs of the Indian market; without creating a bubble. Apart from the benefit to clients in terms of sustained availability of micro credit and for MFIs in terms of self-regulation and sustainability of growth, on implementation of these initiatives, a goldmine of information would be available for research and analysis; enabling independent experts to provide a more comprehensive evaluation of the industry – including whether a bubble is around the corner!

While there is no concrete evidence of a bubble as yet, a bubble in the near future cannot be completely ruled out. In particular, Alpha acknowledges that unbridled or uncontrolled lending combined with high growth rates could potentially cause a bubble. And this is exactly where Alpha & MFIN have taken significant measures well in advance of any possible bubble creation and believe that Indian MFIs are poised to avoid this scenario by adopting prudential measures as mentioned in this article. And if MFIs in India can ensure sustained growth through a strong self-regulated mechanism to ensure that a bubble does not come in the way of servicing the millions of customers who need microcredit, we believe that credit can definitely be given to the MFIs for learning from others’ mistakes!